A minimum price

A minimum price sets the lowest level that a good or service can be legally sold for. The desired effect is that consumption of the good will fall, resulting in a welfare gain to society.

Setting a minimum price for alcohol (or other demerit goods) has become an increasingly common strategy for trying to tackle over-consumption.

Graphically, the effect is that demand contracts, to ‘b’ and supply extends, to ‘c’. This would create a surplus of the good.

However, this only happens if the minimum is set above the market rate. If set below, the market rate prevails.

Example

If we consider the following data on market demand and supply for an alcoholic drink, we can see that the free market equilibrium is at a price of 4 euros. If, however, a government sets a minimum price of 6 euros, then demand will contract from 800 units to 400. However, supply will extend to 1200, creating a surplus of 800 units.

The effect of price elasticity

The impact of a minimum price depends on the price elasticity of demand and supply.

When consumers are unresponsive (inelastic) in terms of their response to a minimum price, the reduction in consumption will be relatively small. Similarly, when supply is inelastic, producers cannot increase production quickly, with the result that the surplus is small.

Evaluating a minimum price

1. Clearly, with many demerit goods demand is relatively habitual, and consumers may well carry on consuming - hence the welfare gains may be modest.
2. In comparison with a specific indirect tax, minimum prices generate no direct revenue to the government, although ad valorem taxes (percentage taxes, such as VAT) will increase as price increases.
3. The impact of the minimum price is likely to be regressive, with a more significant impact on the 'poor'.
4. Producers may suffer, with jobs lost in the industry and with resulting negative externalities.
5. As with all types of government intervention there is the potential issue of information failure - governments are unlikely to set a minimum price that reduces consumption to the exact quantity that would achieve optimum levels of welfare.
6. Finally, there is the possibility of some 'unintended consequences' of the policy - for example, some sellers may turn to the hidden economy to sell at below the legal minimum.